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JANUARY 1988 NUMBER SEVENTY-FOUR Employee stock ownership plans can enhance corporate perform- ance, but most ESOPs have not been structured to realize their full potential in this area. Employee Stock Ownership Plans: Impact on Retirement Income and Corporate Performance Employee stock ownership plans, or ESOPs, are employee benefit plans that provide shares of stock in the sponsoring company to participating employees. They have sometimes been credited with the potential for improving U.S. corpo- rate performance and employee attitudes. The U.S. General Accounting Office (GAO) released a report in late 1987 finding that most ESOPs have not improved corporate performance as measured by profitability and productivity. GAO acknowledges, however, that when ESOPs include broad employee participation in company decision making, they have a greater impact on corporate performance. Other studies confirm this latter finding (Quarrey, 1986). In addition, a survey by Rosen, Klein, and Young found that the amount of stock contributed to participants' accounts was the single most important factor in boosting employee satisfaction with the ESOP, which, in turn, might be linked with better corporate performance. Most ESOPs, however, have not been structured to realize their full potential in these areas. Tax-credit ESOPs covered 7 million employees in 1983, more than other types of ESOPs. These plans havebeen popular with companies, who could take a credit against income tax for employer contributions. But tax-credit ESOPs typically provide only a limited amount of ownership in a company. For example, in 1983, tax-credit ESOPs provided a median account balance of just under $3,000, compared to between $5,000 and $8,600 for other ESOPs. Moreover, only 5 percent of tax-credit ESOPs own more than 25 percent of their companies, compared to 44 percent of leveraged ESOPs. Leveraged ESOPs, which borrow funds to acquire employer securities, typically provide a larger degree of ownership. These ESOPs may increase in popularity as a result of the elimination of tax-credit ESOPs in the 1986 Tax Reform Act and the increased tax incentives to leverage included in other recent legislation. ESOPs have also attracted increased attention of federal policymakers, who have voiced concern about their use as a corporate financing tool in leveraged buyouts and about their relative riskiness as retirement income vehicles because of the con- centrated investment in a single corporate stock. ! A monthly periodical from the EBRI Education and Research Fund devoted to expert evaluations of a single employee benefit issue ESOPs have been used to help save struggling compa- • Introduction nies. An employee stock ownership plan, or ESOP, is a tax- Leveraged ESOPs can participate in multi-investor qualified employee benefit plan that provides shares of leveraged buyout transactions. Under such transac- stock in the sponsoring company to participating tions, two or more investors each buy a large block of employees. ESOPs resemble other employee benefit stock in the target company. The use of ESOPs in these plans in that they supplement other forms of employee transactions has been controversial, with critics some- compensation. Like other compensation supplements, times charging that ESOP abuses outweigh potential ESOPs have implications for employee recruiting, benefits and calling on policymakers to regulate ESOP performance, and morale. Like other tax-favored use more strictly, or to curtail or eliminate ESOP tax benefit plans, they represent forgone tax revenues to the breaks. federal government. _ __ _ ESOPs (and stock bonus plans) are sometimes credited _ _" with greater potential than other forms of compensation to improve employee motivation because ESOP partici- ESOPs have been advocated as a way to pants acquire an ownership interest in the company for broaden the ownership of productive capital which they work. In addition, ESOPs are sometimes established in conjunction with programs that encour- and thereby provide the means for more indi- age greater employee participation (work place "de- viduals to participate gainfully in the economy mocratization"), further affecting the incentive struc- with capital rather than through labor alone. ture. Some critics assert, however, that ESOP use rarely involves a substantial change in employee relations or _ _ ,_ work place philosophy but instead primarily reflects interest in bottom-line tax advantages. Furthermore, some who favor more traditional management styles ESOPs have been advocated as a way to broaden the oppose work place programs that give rank-and-file ownership of productive capital and thereby provide workers more control, the means for more individuals to participate gainfully in the economy with capital rather than through labor An ESOP is a type of defined contribution plan. Like alone. Some ESOP advocates contend that the existing other defined contribution plans, ESOPs are designed to concentration of stock ownership is a reflection of provide deferred compensation and can provide cash fundamental institutional flaws and a cause of many of benefits at retirement or a portable benefit upon separa- the nation's current economic problems, and they tion from service. However, because ESOPs must be advocate ESOPs as a way to correct some of these flaws. invested primarily in the stock of the sponsoring But just how far ESOPs could potentially broaden company, they are often characterized as riskier than ownership is not yet clear, and there is disagreement other defined contribution plans, which usually hold about the economic benefits of such broadening. more diversified portfolios. In recent years, use of ESOPs and other stock ownership ESOPs are a unique type of benefit plan because they plans has grown rapidly. The U.S. General Accounting are permitted to borrow money on a tax-favored basis Office (GAO) identified 4,174 active ESOPs in 1985. to purchase employer stock. (ESOPs that exercise this These plans covered 7.1 million participants in 1983. option are called "leveraged ESOPs.') Thus, an ESOP The elimination of the tax-credit incentives for ESOP can be an advantageous corporate financing tool under contributions under the Tax Reform Act of 1986 (TRA some circumstances. ESOPs can be used to create a "86) could reduce these numbers significantly, however, market for a retiring owner's stock, to finance capitali- because 26 percent of these ESOPs, covering 90 percent zation, or to finance acquisitions. In isolated cases, of participants in 1983, took advantage of the tax-credit 2 • EBRI Issue Brief January 1988 provision (GAO, 1986). If ESOPs using the tax credit called a "leveraged ESOP"; one that does not is some- are excluded, the number of employee ownership plans times called a "qeverageable ESOP." (If a leverageable (including ESOPs, stock bonus plans, and money ESOP makes no provision for leveraging in its plan purchase and profit sharing plans that invest in em- document, it may be called a "nonleveraged ESOP.') ployer stock) increased from 1,601 plans covering Another type of ESOP, the tax-credit ESOP, is not 248,000 employees in 1975 to 8,046 plans covering 7.0 permitted to use leveraging but may take a tax credit for million in 1986, according to the National Center for employer contributions to the plan. Tax-credit ESOP Employee Ownership (NCEO, 1987). provisions, enacted as part of the Tax Reduction Act of 1975, have since expired. Many forces have contributed to this rapid growth. Perhaps most significant is the legislation enacted by Congress to encourage employee ownership. Cur- rently, leveraged ESOPs enjoy more liberal deduction limits than other defined contribution plans, and The most important characteristics that distin- lending institutions enjoy favorable tax treatment for guish ESOPs from other defined contribution loans made to ESOPs. Former Sen. Russell B. Long (D- plans are the requirement that an ESOP invest LA), a long-time advocate of ESOPs, has written that "primarily" in employer stock and the ability during his tenure with the Senate Finance and Com- merce committees, "19 separate pieces of legislation of an ESOP to borrow money on a tax-favored were enacted improving the prospects for employee basis. ownership" (BNA/NCEO, 1987). After defining ESOPs, this Issue Brief will provide a brief history. It will explain how ESOPs work, outline current legal provisions that encourage or regulate As defined contribution plans, ESOPs are granted ESOP use, and discuss current trends. Issues confront- certain tax advantages under the Internal Revenue Code ing employers, employees, and policymakers will be (IRC). These include the deductibility, within certain highlighted. This Issue Brief will examine the effects of limits, of contributions to the plan trust and the tax- ESOPs on employee attitudes and corporate perform- deferred build-up of asset earnings in the trust. ESOPs ance and will review public perceptions of ESOPs. are also restricted by many of the same laws that govern Finally, this Issue Brief will consider the outlook for other tax-qualified defined contribution plans, includ- ESOPs in the near future, summarizing current federal ing nondiscrimination requirements, distribution rules, legislative and regulatory developments affecting and minimum participation and vesting standards. ESOPs and state employee ownership initiatives. However, there are important exceptions (detailed later in this Issue Brief). "_ Background The most important characteristics that distinguish Definition ESOPs from other defined contribution plans are the requirement that an ESOP invest "primarily" in em- ESOPs are qualified with the Internal Revenue Service ployer stock and the ability of an ESOP to borrow (IRS) as stock bonus or money purchase pension plans, money on a tax-favored basis. Other legal restrictions In addition, ESOPs are sometimes structured as profit unique to ESOPs are generally designed to address sharing or 401(k) plans. ESOPs differ from pure stock these two special features. bonus plans in two important ways: a stock bonus plan (1) is not required to invest primarily in employer secu- History rities; and (2) does not use leveraging.

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